1. Field of the Invention
The present invention relates generally to a method for operating a managed investment product and to the managed investment product and, in particular, to a method and product for improving performance and performance characteristics in managed investments that employ incentive or performance based compensation.
2. Description of the Related Art
Traditional or “long only” investing (long term, buy and hold investing) generally involved stocks, bonds or some combination of the two. “Long only” investing has been widely accepted as the preferred method of acquiring prudent investment access, especially among institutional investors. An entire industry has developed to support this type of investing, with a highly evolved framework for the analysis of the proper relative return for a given level of risk. Most investments are easily categorized, and nearly all have a commonly accepted index or benchmark from which to determine success or failure. More recently, “alternative” investments (such as hedge finds, etc.) having very different characteristics and constraints have been making their way into institutional portfolios.
Risk vs. Reward
Today most investors, especially institutional investors, look upon price action or volatility (movements up or down) as the definition of risk. The Capital Asset Pricing Model (CAPM) is a widely accepted model of the relationship between the expected risk of an investment as it influences the expected return. This conceptual framework teaches that in order to realize higher returns, one must accept higher risk. Further, the expected return of an investment, the beta or systematic risk component, is a measurable constant. Beta (β) is the covariance of an investment relative to others; for example the S&P 500 Stock Index (S&P=Standard & Poor's) has a beta coefficient of 1 while a single stock with a coefficient of 0.5 would be expected to experience half the risk and half the return. Any excess return above that which is expected relative to the amount of risk taken is typically attributable to manager skill and is referred to as alpha (α) generation. The simple linear regression Y=α+βX, where “β′” defines beta and “α” defines alpha is the equation commonly used to ascribe added manager and strategy value relative to other investments. Note that Y is the investment portfolio return, while X is the market return less the risk free rate.
Source of Investment Gains
With traditional investments, the beta portion of performance (the portion attributable to systematic exposure common to all securities of a similar class) of the investment is typically the far more important component as it represents the return generally available from an investment in the marketplace and is the basis for comparison. All similarly focused managers would be expected to provide this return and are measured by how well they do so. On the other hand, the excess return, or “alpha”, generated by traditional investment managers is not usually significant in size. Because systematic or market-driven factors make up the most important portion of performance and the contribution attributable to the specific manager's skill is typically marginal, traditional investment managers generally charge a straight fee based on assets under management (e.g. 75 basis points, which equals ¾ of one percent).
These concepts also more generally apply to the performance of return on capital expected by an investor in broad array of financial and contractual relationships where there is both an expected or average performance expectation and the potential for a generated excess return by a compensated manager.
Alternative Investments
In recent years, however, non-traditional or alternative investments have grown in importance. Examples of alternative investments classifications include:
Venture Capital
Private Equity
Global Macro Arbitrage
Relative Value Arbitrage
Event Driven Arbitrage
Managed Futures & Currencies
Real Estate
Natural resources
Entertainment and athletic ventures
Securitizations
Some of the distinguishing characteristics associated with alternative investment managers are:
Largely skill-based investment returns
There is a recognized component of alpha-based returns
The ability to buy long or short on the markets traded
Performance-Based Incentive Fees
An important difference between traditional and alternative investments involves the issue of performance-related compensation. With alternative asset managers, “alpha” is the more important return component. While alternative investment managers also can be compensated based on asset size, a portion of such manager's return is typically tied to the performance of the portfolio. Manager skill in generating absolute returns (or “alpha”) is the key determinant in whether the alternative investment manager will succeed or fail. With a source of returns that is quite different than for traditional investments, such managers are also compensated for these returns quite differently. The marketplace has determined that the most appropriate reward for the alternative investment manager is to tie the manager's compensation to the manager's performance—the manager's ability to generate alpha. (The traditional manager, in contrast, is typically paid with a flat fee, as the traditional investment manager's main focus is delivering beta, not alpha.) This performance-based form of compensation benefits both the investor and the manager because both have interests that are aligned. Manager skills that improve performance on an absolute basis (thereby having a positive alpha) are rewarded through manager participation in that performance.